Illustration by Bloomberg View
The Basel III banking rules are regulators’ third attempt in about two decades to address one of the biggest threats to the global economy: the tendency of financial institutions to go bankrupt during bad times. Among other reforms, the rules require banks to finance their activities with more equity, or capital, as opposed to debt. The equity helps guarantee that the bank’s own shareholders will absorb any losses, instead of turning to taxpayers for bailouts.
Bankers don’t particularly like the new rules. Jamie Dimon, chief executive officer of JPMorgan Chase, has gone so far as to call them “anti-American,” suggesting that the U.S. break with global regulators and go its own way. Dimon is absolutely right, but for the wrong reasons.
Despite Dimon’s complaints, the capital requirements aren’t terribly burdensome. For the biggest banks, including JPMorgan Chase, they amount to somewhere between 3 percent and 5 percent of assets, similar to putting $3,000 to $5,000 down on a $100,000 house. In the bizarre math of Basel III, that comes to 10 percent of risk-weighted assets. Dimon and other bankers say that’s too much. They warn that the need to raise more equity will increase their costs, forcing them to charge higher interest rates on loans, with dire repercussions for the economy.
Even if one assumes that banks’ costs would rise (a questionable assertion), there are other ways to offset them. Consider bankers’ pay. Average U.S. wages in finance are about 70 percent higher than in other industries. Erasing that compensation gap—it didn’t exist 30 years ago—would cut operating costs just about enough to raise a typical bank’s capital ratio from 5 percent to 10 percent without increasing lending rates and without impairing shareholders’ profits.
A better reason to dislike the Basel rules is that they don’t go far enough. The best research available, from a group of researchers led by former Morgan Stanley economist David Miles, has found that even extremely high capital ratios—as high as 50 percent—would actually be good for the economy, because the benefit of reducing the frequency of financial disasters far outweighs any costs. Optimal capital would probably be about 20 percent of risk-weighted assets, equivalent to tangible equity of 7 percent to 10 percent. That’s double the level in Basel III.
Worse, the Basel rules create perverse incentives. Instead of defining a bank’s equity simply as a share of its total assets, Basel assigns each asset a weight that is supposed to correspond to its risk. Government bonds, for example, have a zero weight, as if they had no risk at all. This feature makes them very attractive and helped turn Europe’s debt problems into a global crisis by encouraging banks to invest heavily in the high-yielding debt issued by countries such as Greece.
The risk-weighting system is also far too complex and too easily manipulated to provide a reliable picture of how much capital a bank really has. For a large bank such as JPMorgan, coming up with a risk-weighted ratio requires sorting assets into more than 200,000 different buckets. Even unintentional errors can skew reported capital ratios by several percentage points. That’s a problem when the starting point is only 10 percent.
The flaws in the Basel rules have led Britain, which boasts one of the world’s largest concentrations of big banks, to create its own, more stringent requirements. Under a plan Britain’s Conservative-led government intends to adopt, big banks must have loss-absorbing capacity—consisting of equity and debt that converts into equity in times of stress—of at least 17 percent and as much as 20 percent.
The U.S. would do well to follow and go far beyond Basel. It’s crucial to prevent banks from taking the kinds of risks that can result in big bills for taxpayers and economic misery for millions of families. Allowing that to happen again would truly be anti-American.
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